The history of inflation rate

Stock prices change all the time due to numerous factors. In the field of stock investing, different professionals analyze different factors that lead to changes in stock prices. This includes technical analysis, fundamental analysis of companies, economic indicators, and other factors. In this blog, I will share with you the main takeaways from Howard Marks' "Thinking About Macro" Memo, which highlights the relevance of using economic indicators in determining future stock prices. Howard Marks is an investor well known for his insightful memos on his investing views and his book "Mastering the Market Cycle".

Ever since the 2008 Global Financial Crisis, the US Fed, Treasury, and Congress will provide stimulus to individuals and companies to boost economic growth. This provides a hugely positive indicator to investors that prices are going to rise shortly due to higher spending power, including asset prices. This also happens in the 2021 Covid'19 Market Crash, where the United States had chosen a similar strategy of providing huge stimulus and keeping the interest rate low till 2023 tentatively. As a result, stock prices have skyrocketed from March 2020 to the end of 2020.

However, inflation fear starts to rise since the beginning of 2021, the 10 Year US Treasury Yield rate increase from approximately 0.92% to as high as 1.78% within 6 months. (Market Watch) This is mainly caused by the high level of inflation fears among investors, causing high volatility in stock prices and price correction among technological stocks.

For years, central bankers in the U.S., Europe and Japan have targeted a healthy 2% rate of inflation, but none of them have been able to produce it. This despite continuous economic growth, significant budget deficits, rapid expansion of the money supply through quantitative easing, and low interest rates – all of which are supposed to be inflationary.

"Thinking about Macro" - Howard Marks

Nonetheless, Howard Marks has highlighted that sustained and healthy inflation levels are hardly achievable by stimulus policies and low-interest rates, which affirms the possibility of inflation not occurring despite the high level of stimulus provided by the US government.

Finally, for roughly the last 60 years, economists have trusted the so-called Phillips Curve, which posits an inverse relationship between unemployment and inflation: the lower the unemployment rate, the tighter the labor market, the more negotiating power workers have, the more wages rise, and the greater the increase in the prices of consumer goods. But the U.S. unemployment rate fell throughout the last decade – ultimately hitting a 50-year low – and still there was no material increase in inflation. Thus, few people talk about the Phillips Curve anymore.

"Thinking About Macro" - Howard Marks

In July 2021, Federal Reserve Chairman Jerome Powell had highlighted the possibility of having tightening policies such as increasing interest rates only when companies have reached maximum employment rate and consumer prices have increased consistently. Hence, Howard Marks described inflation as "mysterious" due to the uncertain causes and cures, where investors should rely more on other areas to predict stock prices rather than inflation.

Invest based on valuations, not predictions

The bottom line is that hundreds or perhaps thousands of people make their living as professional market forecasters, despite the fact that the median forecast is of no value: wrong on average, positive in good years and bad, and way off target when an accurate forecast would have been most profitable.

"Thinking About Macro" - Howard Marks

In the view of Howard Marks, invest solely based on predictions from any professional investors or institutions will most likely be inaccurate. Investors do not have to know the exact future in terms of stock prices and should maximize their returns without any forecasting knowledge.

This aligns strongly with my investing philosophy, on using price valuations to invest in stocks. In my opinion, the ability to predict stock prices is an additional bonus on investors' returns but not sustainable in a long run.

Are stocks overpriced now?

Not for all.

For example, with the p/e ratio of the S&P 500 in the low 20s, the "earnings yield" (the inverse of the p/e ratio) is between 4% and 5%. To me, that seems fair relative to the yield of roughly 1.25% on the 10-year Treasury note. If the p/e ratio were at the post-World War II average of 16, that would imply an earnings yield of 6.7%, which would appear too high relative to the 10-year. That tells me asset prices are reasonable relative to interest rates.

"Thinking About Macro" - Howard Marks

Most of the stock prices are just overvalued or undervalued. In my opinion, stock prices may stay at their intrinsic (true) values for only a short period. Also, the intrinsic values depend on the investment horizon period. Investors can prepare to invest in undervalued stocks when those companies experience a short-term backlash in terms of unsatisfactory earnings and other short-term negative news.

What investors should do?

It makes little sense to significantly reduce market exposure: when the most important rule in investing is that we should commit for the long run, remaining fully invested unless the evidence to the contrary is absolutely compelling.

"Thinking About Macro" - Howard Marks

Conclusion: we can't predict, but we can prepare. This highlights the fact that investors should consistently invest in innovative companies at good prices for the long run.

To view the full memo: https://www.oaktreecapital.com/docs/default-source/memos/thinkingaboutmacro.pdf

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